OPEN GOODS AND CAPITAL MARKETS

The most effective way to reduce the power of incumbents to affect legislation is to keep domestic markets open to international competition. It is especially important to keep financial markets open. This is the main lesson we have drawn from our historical analysis, a lesson that cannot be overstressed today at a time of growing opposition to open borders. Countries have little incentive to close their borders to trade and capital flows unilaterally when the rest of the world is open. This is because goods and capital will leak through anyway unless the country goes the totalitarian route of a Cuba or a North Korea. But a mass movement against open borders, even if only in a few large countries, can make it attractive for politicians to close borders. This is the danger posed by the growing antiglobalization protests that have become louder, larger, and more violent in recent years.

To these growing protests, economists have responded by emphasizing the efficiency gains generated by international trade—through the law of comparative advantage—which allow countries to specialize in the product they produce best, enhancing worldwide production and making all countries better off.¹² On the other hand, economists have generally been lukewarm in their support for free international capital movement. While we certainly do not dismiss the importance of the efficiency gains generated by trade, we emphasize a different argument in favor of openness: its effect in reducing the power of domestic incumbents. Free movement of capital plays a central role here.

Why, according to us, is openness beneficial? The answer is blindingly simple. Openness creates competition from outsiders—outsiders that incumbents cannot control through political means. A commitment to openness forces incumbents to abandon politics and focus on the tougher task of defending their position in the marketplace the hard way: by becoming more efficient. Because the United States could not dictate British financial regulation, the Euromarket flourished and was able to threaten U.S. dominance in the financial world. Eventually, the competition and alternatives the Euromarket generated helped the development of financial markets in both the United States and the United Kingdom, as well as in many other countries around the world. Put another way, openness forces political authorities to compete in improving the general economic well-being of the entities they rule. To the extent that political authorities would otherwise tend to focus on the well-being of an influential few rather than the unimportant many, openness tends to benefit economies that open up.

While openness is clearly beneficial for developed economies with sound infrastructure underlying their goods and financial markets, we have seen that sudden liberalization can be risky for underdeveloped economies. Even if a liberal, market-oriented economy is more productive and fair, economies that have spent decades protected from competition need to create the institutions that will permit a functioning market economy. Subjecting these economies at short order to the full gale-force winds of international competition may be harmful, in part because it may wipe out those very constituencies—the professional classes, small and medium-sized entrepreneurs, commercial farmers—that can push for a market economy.

The right policy for the large developing economy, according to some, is to limit competition until the institutions necessary for a market economy are in place.¹³ But there is a great risk in such a policy of gradualism: by slowing down the liberalization process, it might bring it to a standstill. If incumbents knew that opening up to competition hinges on infrastructure and skills being improved, they would simply block any movement on either front. In fact, while gradualism would predict that financial-sector reforms should precede the opening up of a country to capital flows, in practice they seem to follow it.¹⁴ So the dilemma for a developing country that has a reforming government is how to create a commitment to increase the level of competition while allowing time for market institutions to be built.